Economic Crisis Workshop www cpegonline org March 2011

Economic Crisis Workshop www. cpegonline. org March 2011 Dr. William Barclay

How Serious Is This Economic Crisis: Some Dimensions • Jobs lost: 12/07 – 12/09 = 8. 8 million – 9. 6% officially unemployed, Oct 2010 (14. 8 million); 8. 9% 2/2011 (13. 7 million) – These numbers double if we include “hidden” unemployed: (working part time/want full time) + dropped out of labor force because don’t believe jobs are available – about 20% un and under employed (approx 30 million) • • Foreclosures: >800, 000 in 2008, 3. 1 million foreclosure notices; in 2009; 1 foreclosure every 13 seconds (24/7) = 2. 4 million, 1 in 10 home “owners” may face eventually face foreclosure 20% decline in household net worth in 2008/09 (loss of $13 trillion in wealth) “Big Three” auto companies teetered on edge of bankruptcy US GDP fell at an annual rate of 6. 2% in last quarter of 2008 Stock market dropped 55% Oct 2007 – March 2009 GDP not yet returned to pre-Great Recession peak – the longest such period since WWII On all measures this is the most severe economic collapse since the 1930 s CPEG Economic Crisis Workshop - Barclay 2

Was it just an Accident? CPEG Economic Crisis Workshop - Barclay 3

You've heard of mental depression; this is a mental recession…we have sort of become a nation of whiners. - Phil Gramm Karl Rove Newt Gingrich Workshop CPEG Economic Crisis - Barclay 4

If you remember nothing else from today…. . • The economic crisis in which we are mired was not an unforeseeable accident • There were a series of policies – political decisions – that led us to where we are • Taken together, these decisions and policies represent a way of looking at and thinking about the world: neo-liberalism CPEG Economic Crisis Workshop - Barclay 5

How Did We Get Here? • Three causes: – Long term trend towards increasing economic inequality in the US – Financial deregulation, credit, and debt – Change in US Role in World Economy • Let’s talk about each CPEG Economic Crisis Workshop - Barclay 6

The First Cause Growth and Impact of Economic Inequality

Inequality of Income in US • • • How much income inequality is there? How has it changed over time? We will answer these questions by: – Dividing all US households into 6 groups ranked by average income • Four of these are income “quintiles” (20% of all households) • We have divided the highest income quintile into the top 1% and the other 19% • Same number of households in each quintile (approximately 22, 500, 000 households in 2006 vs. 16, 200, 000 in 1979) • Compare average after tax income in each group in 1979 and 2006, using 2006 dollars ($1 in 1979 = $2. 78 in 2006) and share of total income • Each marker on the floor represents $5, 000 or $10, 000 of 2006 income • Our representatives will start by opening their 1979 envelope and walking to the marker (or space in between markers) that represents the average income for that quintile in 2006 dollars for 1979 • The top 1% of households by income will also walk to the appropriate marker • After we see where we all are in 1979, each quintile and the top 1% will then open their second envelope and walk to the appropriate marker as I call their quintile CPEG Economic Crisis Workshop - Barclay 8

Average Income by Quintiles and Top 1%, 1979 and 2006 (2006 $) CPEG Economic Crisis Workshop - Barclay 9

Percent Income Shares by Quintiles and Top 1%, 1979 and 2006 Distribution 1979 Distribution CPEG Economic Crisis Workshop - Barclay 10

How Did Inequality Grow in the US: Two Periods • In the 1948 – 79 period, average household income grew by almost $21, 000 and the distribution of that income growth was: – 33% to the top 10% of households – 67% to the remaining 90% of households • In the 1980 – 2007 period, average incomes grew by almost $12, 000, the distribution of that income growth was: – 98% to the top 10% – 2% to everyone else • Note: income grew much more rapidly (and as a percent of initial income) in the more equal period than in the more unequal period – And we know that most of the growth in the latter period was actually even more concentrated CPEG Economic Crisis Workshop - Barclay 11

Why Did Inequality Grow So Much in the US: I • First, explanations that don’t explain – but do have a political function – Was it skill based technological change (SBTC)? • What are the unique – very unique – skills that the top 1% possesses? – Is it education? • Same question: do the top 1% have that many more degrees? • The relative returns to college vs HS education have not grown significantly – Growth in top incomes have dramatically outpaced income growth for all college educated workers CPEG Economic Crisis Workshop - Barclay 12

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Why Did Inequality Grow So Much in the US: II • Increasing inequality was the result of economic policies – Dramatic decrease in the tax rates for top incomes – Increased anti-union activity and decreased enforcement of the FLSA – Failure to increase the minimum wage propelled the growth of a low wage sector – De – actually re – regulation of industries with the new regulations favoring owners over workers and consumers (e. g. bankruptcy “reform, ” trucking dereg and especially financial re-regulation) CPEG Economic Crisis Workshop - Barclay 14

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What Happens When This Large an Income Redistribution Occurs? • Rapid increase in income (and wealth) concentration reshapes both politics and culture – Directly: Large donors have more to give to political campaigns and thus have become more important – Indirectly: Wealthy families have founded and funded research institutes and think tanks and reshaped the universe of political discourse – Labor and community groups became less influential • What was the cumulative effect? – Huge growth of financial sector in the US – Tax cuts - concentrated on top 1% of households – Rapid growth of financial and household debt • Remember our two periods – Did we at least get superior economic growth • This is often argued as a worthwhile trade off for an economy in which the market is dominant CPEG Economic Crisis Workshop - Barclay 16

The Impact of Growing Economic Inequality: The Average Cost of Senate and House Campaigns CPEG Economic Crisis Workshop - Barclay 17

CPEG Economic Crisis. The Dr. Wm Barclay - Workshop - Barclay Financial/Economic Crisis 18 18

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Could We Solve the US Deficit/Debt Problem? • Corporate taxes as a percent of the Gross Domestic Product are at the lowest on record • At $1. 6 trillion, third quarter corporate profits were the highest quarterly figure recorded since record keeping began 60 years ago. • Each year US corporations avoid >$60 billion in taxes by shifting revenues to non-US locations, even when the revenues are generated by sales in the US • A one time 14% surcharge on top incomes would more than pay for the $1. 6 trillion budget deficit projection for 2011 • Or maybe we should require public sector workers to pay more into their pensions and take pay cuts? ? CPEG Economic Crisis Workshop - Barclay 22

Average Annual GDP Growth per Capita, Neo-Liberal Period (1979 – 2008) CPEG Economic Crisis Workshop DSA/CPEG 2 -12 -2011 - Barclay 23

The Second Cause Credit, Debt and Financial Deregulation

Financial Regulation: The New Deal • 1933 Congress passed the Glass-Steagall Act – Included Federal Deposit Insurance Corporation (FDIC) – Also contained the first federal minimum wage – Divided financial institutions into distinct groups • Commercial banks: take deposits (covered by FDIC), make loans to businesses and individuals • Investment banks: underwrite and sell securities as brokerdealers (stocks, bonds), trade for own account, merger and acquisition • Insurance companies CPEG Economic Crisis Workshop - Barclay 25

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Glass. Steagall Act CPEG Economic Crisis Workshop - Barclay 27

What Happened to Glass-Steagall? • During 1980 s financial institutions began lobbying to repeal the separation portions of Glass-Steagall – Depository Institutions Deregulation and Monetary Control Act of 1980 eliminated Fed control of savings account interest rates • 1998 Alan Greenspan (Fed Reserve Chairman) granted Citi. Group a temporary license to combine investment and commercial banking – Expired in two years unless Glass-Steagall was repealed – 1999 Gramm-Leach-Bliley (yes, the Gramm in our picture) Act repealed the separation portions of Glass-Steagall • “One Stop Shopping” in the financial super-mall • How did these “reforms” change finance, financial incentives and the financial environment? – Many ways but mortgage lending is the most important for understanding the financial crisis of 2008 ff CPEG Economic Crisis Workshop - Barclay 28

After Glass-Steagall Act’s Repeal “one-stop shopping” CPEG Economic Crisis Workshop - Barclay 29

Mortgage Banking Model Changes: I • Mortgage banking used to be: – Assess the financial standing of the potential home buyer – Make a loan based on income and long term financial outlook • The 30 year fixed mortgage was a product of the New Deal – Carry the loan in bank’s portfolio – Incentive: risk averse • Repeal of Glass-Steagall opened door to very different model – – – • Review credit score Make a loan (“initiate” a loan) Sell (“distribute”) the loan for packaging into mortgage backed securities (MBS) “Securitization” of mortgages allows them to be sold to other investors Make the next loan Incentive: make as many loans as quickly as possible and get them out the door “These new [financial] technologies lay off all the risk of highly leveraged institutions on stable American and international institutions” – Alan Greenspan CPEG Economic Crisis Workshop - Barclay 30

Mortgage Banking Model Changes: II • New entities came into mortgage banking: brokers, hedge funds, etc – Lightly regulated – e. g. , most subprime mortgages not issued by entities subject to the Community Reinvestment Act – “Shadow” banking emerges • Who drove the decline in lending standards, the push to increase the amount of mortgage loans outstanding, securitization and the ratings assigned to MBS? – Did borrowers, hoping to buy houses, come in and say, “Give one of those exploding 2/28 or 3/27 loans that I can’t afford and, oh by the way, I want to lie about my income? ” • Incentive was to make subprime loans rather than prime: – Countrywide Mortgage: prime loans sold to investors had average profit margin of 0. 93% vs subprime average profit margin of 3. 64% • Fraud by lenders was widespread – Ameriquest – largest US mortgage lender (for a short time!) – TX Ranger’s Stadium, Super Bowl ads, Rolling Stones 2005 US tour • • Brokers developed fraud specialties – creating mortgage histories or doctoring W-2 forms to change income levels (observing tracing of signatures) & dismissal of “Good Faith Estimate” required under federal law Ameriquest took appraises off their lists if the valuations didn’t meet their needs – “If they have a house, if the owner has a pulse, we’ll give them a loan” – Russ Jedniak, Guardian S&L CEO – FAMCO bugged conference rooms to overhear borrowers discussions about what they could afford – Extensive use of Ro. Bo signers CPEG Economic Crisis Workshop - Barclay 31

Mortgage Lending: Housing Debt and Foreclosures • 2003: housing borrower is pushed to take out a loan that they are unlikely to be able to repay unless house prices rise continuously – Court records leave no doubt that lenders pushed – even to the point of lying or urging borrowers to lie about their financial situation/prospects – Result is a highly leveraged mortgage borrower • Banking is a simple business with one crucial decision – What is the probability that a borrower can repay the loan? • New mortgage lending model ignored that risk • 2005: House prices rise and equity is extracted • 2007: House prices fall – leverage destroys their equity and pushes them underwater CPEG Economic Crisis Workshop - Barclay 32

Mortgage Borrower: 2003 – 2007 • 2003: house value $300, 000; loan at $294, 000 = leverage of 50: 1 • 2005: house value $350, 000; refinance with $320, 000 loan – $26, 000 withdrawal; $30, 000 equity • 2007: house value $260, 000 – Borrower “underwater” by $60, 000 – $30, 000 equity wiped out – Refinance requires an additional $60, 000 CPEG Economic Crisis Workshop - Barclay 33

Leverage and Investment Banking • Investment banks were partnerships: 1930 s – 1980 s/90 s – Capital at risk: partners assets – Focus on risk management and control of leverage • Beginning in 1985, investment banks became publicly traded entities – Capital at risk: share and bond holders investment • • Bear Sterns – 1985 Morgan Stanley – 1986 Lehman Bros – 1994 Goldman Sachs - 1994 CPEG Economic Crisis Workshop - Barclay 34

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The Third Cause How did the collapse of the US mortgage market become an international economic crisis?

The US in the Global Economy • For several decades before and after WWII, US was a net exporter as well as the world’s largest creditor nation • US balance of trade turned negative in 1970 s and current account turned negative in 1980 s – By mid 2000 s the current account deficit had increased to 6% of GDP, a level that is not sustainable • What was happening – in answering this question we will learn why the economic crisis is not just a US economic crisis CPEG Economic Crisis Workshop - Barclay 37 37

Industrial Policy: The US Case • US economic and political leaders normally reject the idea of an industrial policy – Argument that the “market knows best” – Argument that industrial policies “don’t work” • Consider Japan, China, and Scandinavia • In fact, the US has had a de facto industrial policy – Usually defined as “free trade” • Let manufacturing go offshore • Develop services, especially financial services – Finance as a domestic economic leaders : until 1980 s financial profits had never exceeded 20% of all corporate profits – reached >40% in mid-2000 s – Finance and balance of trade: US comparative advantage in financial services to drive exports – Attempt to balance trade deficit via exporting of services, especially financial services • It hasn’t worked (in case you haven’t noticed) CPEG Economic Crisis Workshop - Barclay 38

Industrial Policy: Exporting Jobs • • Jack Welch (long time CEO of GE): “Ideally you'd have every plant you own on a barge. ” This means no loyalty to any location or any labor force – Contrast: Germany’s Siemans, BMW, Daimler, Thyssen Krupp have agreed to keep jobs in Germany • Germany is a high wage country: manufacturing wages 50% > US: but a very successful exporter • To a significant extent, Jack Welch has described what has happened to US jobs, specially those are large companies – Apple employs more than 275, 000 people to make its IPods, IPhones, etc – 250, 000 of them in Shenzhen (PRC) – US MNCs are less than 1% of total US businesses • Account for 74% of private sector R&D • Pay wages 35 – 40% above non-MNCs • Employ 15% of US workers • • In 2001, 32% of total revenues for the companies in the S&P 500 came from abroad; in 2008 almost half (48%) came from abroad US MNC employment is going abroad CPEG Economic Crisis Workshop - Barclay 39

US MNC’s Export Job Creation CPEG Economic Crisis Workshop - Barclay 40

Problems for the US Dollar • Exporting of jobs/importing of goods = trade deficit – Undercuts the role of the dollar as the world’s reserve currency • Decline in value of dollar vs. Euro and yen (somewhat reversed in last year) – Foreign central banks have diversified holdings – Some petroleum exports now denominated in other currencies (oil is the largest by value commodity in world trade) • Is there something the US could export that would help balance our trade flows? CPEG Economic Crisis Workshop - Barclay 41

Why Would Anyone Buy Debt Based on The Loan Practices as Described? ? • Securitization of assets existed pre-housing bubble but was limited in scope • Change in mortgage lending model required rating agencies to provide assessments of this new flow of securities: AAA ratings were the goal – Here are how some S&P employees described the resulting process: • “We rate every deal. It could be structured by cows and we would rate it. ” • “Let’s hope we are all wealthy and retired by the time this house of cards falters. ” • Why: “They’ve become so beholden to their top issuers for revenue they have developed a kind of Stockholm syndrome which they mistakenly tag as Customer Value creation. ” CPEG Economic Crisis Workshop - Barclay 42

Globalizing the Housing Bubble • Deutsche Bank: 45% of US originated asset backed securities owned by non-US investors (2005) – Total amounted to $3 trillion held by non-US individuals and institutions (1/3 of their total holdings of US assets) – US MBS represented 8% of world total bank loans and securities • A range of non-US institutions bought this debt - e. g Norway town, Iceland’s banks, etc – At year end 2006, European banks alone had over $300 billion of MBS (almost 3. 5 times their total profits in that same year) • Thus the financial impact became of the housing bubble, including its bursting – became world wide – Other countries with similar housing bubbles, e. g. , Spain, UK found themselves hit by both the collapse of the US housing bubble and their own CPEG Economic Crisis Workshop - Barclay 43

What is Neo-liberalism? • Core tenet: markets are self correcting and provide the best (most efficient in use of resources) outcomes if allowed to function – Markets bring together a large number of participants who vote with their dollars • Therefore: – Remove regulatory “restraints” on markets – government-regulated outcomes are always “second best” – Turn activities over to private sector wherever possible – There is no “common good, ” only individuals seeking their personal well being CPEG Economic Crisis Workshop - Barclay 44

Some Political and Economic Signposts • • 1973 Heritage Foundation established 1975 “Supply Side” Economics defined and labeled 1977 Cato Institute created 1982 – 3 Reagan tax cuts reduce top tax rate to 50% from 70% • 1984 Rush Limbaugh starts broadcasting in CA – 1988 Rush Limbaugh moves to NYC and goes national • 1987: Alan Greenspan becomes Chairman of Federal reserve • 1999: Gramm-Leach-Blilely Act repeals portions of Glass Steagall • 2001 Bush tax cuts reduce top tax rate to 35% CPEG Economic Crisis Workshop - Barclay 45

These new [financial] technologies lay off all the risk of highly leveraged institutions on stable American and international institutions. - Alan Greenspan Ronald Reagan Robert Rubin All the evils, abuses, and inequities, popularly ascribed to businessmen and to capitalism were not caused by an unregulated economy of by a free market, but by government intervention into the economy. --Ayn Rand CPEG Economic Crisis Workshop - Barclay 46

What Should Be Done? Ideas on Policies

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What Is (Still) To Be Done • The US needs to: – Effectively regulate – and reduce the size of the financial sector – Create jobs: minimum of 20 million – Stop the foreclosure machine – Raise new revenue to: • Support those whose lives have been devastated by the 2008 finance/economic crisis; and • Fund the projects needed to be competitive in the 21 st century CPEG Economic Crisis Workshop - Barclay 49

Regulating the Financial Sector • Restrict leverage – 30: 1 (or higher) leverage brought down Bear Sterns, Lehman Bros. etc. – If you can’t make money at, for example, 15: 1 you probably should go into another business • Extend regulatory power over all entities that create credit – Commercial banks – remember them? – used to be the primary source of loans – Now the “shadow banking system” of hedge funds, off-books entities, mortgage brokers – all largely unregulated – account for most of the credit • Break up entities that “are too big to fail” – sooner of later they will get the rest of us in trouble • Change the incentive structure: – Require top officers and traders to have all their assets (including house(s), bank accounts, cars) as the backing for a security that is eaten into first if the institution gets into financial problems • Return to the Glass-Steagall division of financial activities CPEG Economic Crisis Workshop - Barclay 50

Develop a Jobs for All Program • The 2009 economic stimulus package would have, at best, taken us back to Dec 2007 levels of employment and unemployment • The failure of the private sector to generate sufficient well paying jobs to meet the needs of the US population is not new – but the current economic disaster highlights it • We need a jobs program that: – Focuses on social investments – Reaffirms importance of public employment – training and employing people in health, education, recreation – Is oriented around the new technologies that redefine sources, costs, and uses of energy (“green technologies”) CPEG Economic Crisis Workshop - Barclay 51

Respond to the Mortgage/Foreclosure Crisis • One idea: – Use the New Deal model of a Home Owners Loan Corporation (HOLC) • HOLC acquired mortgages that were in or were about to go into default – paid discount to original value • Renegotiated the terms – maturity, and interest rates – HOLC actually turned a profit for taxpayers • Support legislation that empowers bankruptcy judges to renegotiate mortgage terms on primary residences CPEG Economic Crisis Workshop - Barclay 52

Raising Revenue for Human Needs Many pundits, economists, etc say we have to lower our sights, we can’t afford universal health care, expanded access to higher education etc. because the current economic crisis is too severe. This was certainly the view of the “Deficit” Commission and is the official position of the Republican Party (and some Democrats) They are wrong. Here are some ideas: • Index and make progressive the Estate Tax (“Paris Hilton Tax”); $150 billion/year • Income tax surcharge of 5% on incomes above $250, 000: $200 billion/year – Still lower than tax rates on these incomes from the 1930 s – 1980 s • • • New tax brackets with higher rates for incomes above a specified level, e. g. , $1 million, $5 million, $10 million and $100 million - $200 billion (estimate) Enact Barney Frank’s (2008) proposal to reduce military spending by 25%: $200 – 400 billion/year Collect taxes on individual and corporate overseas accounts – est $60 – 100 billion/year Enact a wealth tax of 0. 5% on top 1% of households (those with wealth of $5, 000 or more): $75 billion/year Impose financial transaction tax: $750+ billion/year So far we’re at more than $1 trillion – other ideas? (does attacking public sector workers earned benefits and bargaining right address our problem? ? ) CPEG Economic Crisis Workshop - Barclay 53

Some Suggestions for Reading • Kevin Phillips - Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism • Mark Zandi – Financial Shock: A 360º Look at the Subprime Mortgage Implosion • Charles Morris – The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash CPEG Economic Crisis Workshop - Barclay 54

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